Morgan Stanley's commentary on Lumentum's financial report: Gross margin exploded, and more importantly, CPO secured a major order!

The optical communication giant Lumentum has delivered an "explosive" second-quarter performance report, not only exceeding expectations across traditional metrics but also providing solid guidance on key technological pathways for AI computing infrastructure, securing orders worth hundreds of millions of dollars. The company is fulfilling the bullish expectations of Wall Street, even though its valuation has already fully reflected optimistic forecasts.

According to the Wind Trading Desk, Morgan Stanley analysts Meta A Marshall and Mary B Lenox released a new research report stating that Lumentum's non-GAAP gross margin for the second quarter reached 42.5%, exceeding analysts' expectations of 38.6% by 385 basis points, primarily due to product mix optimization and price increases for EML lasers. This performance drove the company's earnings per share to $1.67, far surpassing the expected $1.38.

More importantly, the company has made substantial progress in the emerging CPO market. Lumentum disclosed that it has received a multi-hundred-million-dollar CPO expansion order, which is expected to ship in the second half of 2027. Meanwhile, the OCS (Optical Subsystem) business has a backlog of over $400 million, expected to reach a quarterly scale of $100 million two quarters earlier than anticipated.

Morgan Stanley raised Lumentum's target price from $350 to $420, but maintained an "Equal-weight" rating. Analysts pointed out that despite the company's strong fundamentals, the stock price has already reflected optimistic expectations of approximately $20 earnings per share for the 2027 calendar year, and the current 25 times price-to-earnings ratio valuation is already quite full.

Gross Margin Significantly Exceeds Expectations, Pricing Power Highlighted

Lumentum's gross margin performance in the second quarter became the biggest highlight. The company reported non-GAAP revenue of $665.5 million and earnings per share of $1.67, both exceeding Morgan Stanley's expectations of $648.6 million and $1.38.

The outperformance in gross margin primarily stems from two factors. First is the improvement in product mix, with a higher proportion of revenue coming from high-margin EML lasers and OCS products. Second, the company successfully implemented price increases amid ongoing supply constraints. Management stated that although the company increased capacity by 20% in the December quarter, supply shortages are still persisting, which gives the company pricing power.

The non-GAAP operating margin reached 25.2%, also significantly exceeding Morgan Stanley's expectation of 20.6%. The company demonstrated its ability to enhance both revenue and margins in a strong demand environment.

As a result, Morgan Stanley significantly raised its earnings forecasts. The revenue and earnings per share expectations for the third quarter were raised from $695.3 million and $1.56 to $804.3 million and $2.24. The full-year revenue and earnings per share expectations for fiscal year 2026 were raised from $2.621 billion and $5.60 to $2.915 billion and $7.63.

CPO Business Secures Major Orders, OCS Accelerates Volume

If the current performance is supported by EML, then Lumentum's valuation premium entirely comes from betting on the future AI network architecture—OCS and CPO. The information disclosed in the research report shows that the progress of these two businesses is astonishing CPO secures hundreds of millions in orders: The market had previously focused on the technical exploration phase of CPO, but Lumentum revealed that it has received an additional "hundreds of millions" procurement order (PO) for scale out CPO, expected to start shipping in the second half of 2027 (CY27). This is an important milestone for the commercialization of CPO.

OCS backlog orders surge: The growth rate of the Optical Circuit Switching (OCS) business is faster than expected. The current backlog orders have exceeded $400 million. More importantly, the company expects to reach a single-quarter revenue scale of $100 million two quarters earlier than originally planned. This indicates that the demand for optical switching from AI clusters is accelerating. Most of the backlog orders are expected to ship in the first and second quarters of fiscal year 2027 (i.e., the second half of 2026).

Supply chain status: Shortages persist, EML holds pricing power

Despite Lumentum increasing its capacity by 20% in the December quarter, supply shortages still exist. This supply-demand imbalance provides the company with a strong pricing moat.

1.6T era benefits EML: The company has observed that the majority of initial demand for 1.6T optical modules is directed towards EML lasers. This means that EML still holds a dominant position in the competition for next-generation high-speed modules.

Strong pricing power: Management has clearly stated that due to the widespread demand for laser chips, components, and subsystems, supply remains tight, giving the company pricing power. Morgan Stanley has raised its future profit margin expectations in its model based on the judgment that this price increase can be smoothly passed on to customers.

Valuation risk: High growth has been priced in

Based on the strong fundamentals mentioned above, Morgan Stanley has significantly raised its future earnings forecasts. Analysts expect Lumentum's earnings compound annual growth rate (CAGR) to reach an astonishing 158% from fiscal year 2025 to fiscal year 2027.

Morgan Stanley raised its target price from $350 to $420. This target price is derived from a 28 times price-to-earnings ratio based on an estimated earnings per share of $15 for calendar year 2027 (CY27).

Despite the impeccable fundamentals, Morgan Stanley maintains an "Equal-weight" rating. The reason is that the strong rebound in stock price before and after the earnings report (up 30% from the low) has already priced in some expectations.

The research report points out that the buy-side expectations are even more aggressive than Morgan Stanley's, pricing in an earnings per share of $20 for CY27. The current stock price corresponds to a price-to-earnings ratio of nearly 25 times for CY27 earnings under Morgan Stanley's bullish scenario